Liam Gibson, Wealth of Geeks
While trillions have been wiped from the US stock market this year, one asset class has quietly retained its shine among retail investors: exchange-traded funds (ETFs).
ETFs differ markedly from mutual funds since they are not actively managed but track the performance of a particular index, sector, or commodity and are traded openly on the stock market, rather like regular company equities.
US-based ETFs attracted almost $500 billion worth of new investor capital by the end of October, roughly the same amount as for the whole of 2020. Mutual funds, by contrast, have fared much worse, witnessing a net outflow of almost $800 billion over the same period.
The ETF takeover has been building momentum for over a decade. Ten years ago, mutual funds managed 20% of all US stock holdings, while ETFs made up just 8%. Since then, ETFs have attracted more investor capital than mutual funds every year for the past 11 years. Yet over the past twelve months, the asset class has crossed several critical thresholds.
At the end of 2021, passive ETFs represented 16% of total US-based equities, edging past actively-managed mutual funds, which accounted for 14%. At the beginning of 2022, ETFs grew to become the dominant form of investment fund in the US and by August made up 52% of all US-based equity fund assets by August, per recent research from JP Morgan.
ETF fever is catching on in Europe too. Capital flows into ETFs have exceeded mutual funds on the continent every month this year, per Bloomberg Intelligence.
The data shows this year’s market volatility has not disrupted ETFs’ rise to dominance. Zooming in on exactly what kinds of ETFs have seen a sudden spike in capital inflows suggests the added volatility may have even accelerated the shift to passive investments.
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Buffer Zone
“Buffer ETFs” is one particular subset of ETFs that has taken off in this 2022 bear market, with total holdings popping by 80% this year.
Explicitly designed to limit downside losses while also capping upside gains, these funds have proven a hit with weary investors seeking shelter (or a “buffer”) against the downturn storm.
Unlike regular ETFs, buffer funds do not hold stocks but trade options to track an index. This allows them to buy and sell call and put options to create an upper and lower limit on price swings for their holders. For instance, a specific ETF might offer downside protection on the first 10% of losses and an upper cap of 20% for gains.
However, guaranteeing returns within this range is contingent on the buyer holding the asset for the duration of the outcome period. This is typically one year for most buffer ETFs.
Some analysts see the rise of buffer ETFs as reflective of a broader shift in investors’ risk appetite.
“It always used to be, ‘you know what, I don’t want to miss out on the upside,’” Bloomberg ETF expert Athanasios Psarofagis said in October. “Now I feel like the sentiment has completely flopped: ‘I’m willing to give up some of the upside because the downside right now is so much more important to me.’”
One of the titans of buffer ETFs is Innovator Capital Management, which seized the first-mover advantage when it launched the first buffer fund in 2017. Since then, Innovator has launched over 80 ETFs and now has over $8.8 billion in assets under management.
Innovator still has a long way to go before catching up with the major ETF players, though, such as Blackrock, Vanguard, and SPDR, which each manage north of one trillion in ETF assets.
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Funds with benefits
There are several benefits to investing in ETFs. One prominent perk is the discount on fees. On average, an investor can expect to pay between 0.5% to 2.5% for actively-managed mutual funds. For ETFs, by contrast, the typical expense ratio is around 0.2%.
ETFs are generally more tax efficient than their mutual fund counterparts too. The main reason for this is that ETFs are managed passively, so their fund managers create fewer transactions overall. Mutual funds, however, constantly buy and sell equities in and out of the portfolio, and this higher level of activity typically racks up capital gains contributions.
However, there can be some drawbacks when compared with individual stocks. While ETFs make diversifying across many industries and companies easy, they typically do not pay high dividends compared with individual stocks. Investors looking for passive income will need to seek out ETFs with a substantially higher yield.
The trend toward ETFs continuing through the seismic shocks to the stock markets in recent years suggest the trend toward passive investing is here to stay.
In a sign of the times, Goldman Sachs recently announced its own ETF accelerator. This “white label” platform will assist new ETF issuers with distribution, marketing, capital market support, custody, compliance, seed funding, and other services to streamline the launch process and get new funds to market.
The build-out of such new institutional architecture will likely draw more capital into the ecosystem. This will, in turn, continue to give investors more options to diversify their portfolios and reap the rewards of a gradual, long-term approach to investing.
